–We’re going to find out a lot about how durable demand is for Australian assets in the next few days. The prevailing narrative in the market is that the Aussie dollar—based on its high yield and underlying commodities demand from Asia—is in a long-term bull market. But in the next few days it’s going to be a contest of Japanese housewives versus global hedge-fund traders. The result will determine how far the Aussie market falls.
–The conventional wisdom is that the Aussie dollar is strong and perhaps at a new permanent level of strength against the U.S. dollar (which itself is in terminal imperial decline). The evidence to support this view is Australia’s record terms of trade, where Australia gets more and more for what it sells to the world and pays less and less for what it imports.
–That could be unwinding.
But before we get to the effect on the global supply chain from Japan’s earth quake, what’s the latest from Japan? Honestly, we have no idea. The situation is fluid. That alone is going to keep markets nervous. There was apparently another explosion at a different reactor at the Fukushima nuclear plant this morning. Radiation is leaking and some people are leaving Tokyo for points south.
–Since we have no reliable information about what’s really going, we’re going to confine ourselves to financial observations. The first and most useful one is that the correlation between the Aussie dollar/Japanese yen currency pair and the ASX is holding firm, and it’s turned down. The last time this happened, the global “risk off” trade dominated the market, sent commodities down, and took the Aussie dollar much lower. See the chart below from our colleague Murray Dawes.
“Risk Off” trade back on
Source: Slipstream Trader
–Murray and your editor have been using this chart to determine how much of the strength of the Aussie market and the Aussie dollar comes from foreign “hot money”. It’s an important question. Australia has benefitted from the same kind of speculative bets that helped pump up the oil price in 2008 since the mid-point of last year. But what happens if the disaster in Japan crushes sentiment and terrifies traders back into cash and U.S. dollars?
–It would mean the fundamental underpinnings of the Aussie’s strength might not be as strong as they look. The Aussie gold price would go probably go up. And the yield-hunting money from the U.S. and Japan, where short-term interest rates are effectively zero, might pack up and go home for a bit.
–The question of what Japanese housewives will do is an important one because it gets to how much of the demand for Aussie assets is from carry-trading investors in Japan. You can expect a massive repatriation of Japanese money back into the local economy, back into cash. How much of that money will come out of Australian assets?
–Murray is tracking the technicals on this trade in Slipstream Trader. We’ll keep you posted on his observations this week. In our discussion yesterday with him, we talked about a possible snap-back rally in stocks if the situation in Japan stabilises…and what key lines of support would see the market go a lot lower.
–As we write, the Japanese market is up nearly 6%. But frankly without a better understanding of the price action, it’s hard to know how much of this is program trading, speculation, or even short covering. Murray also pointed out that this could be a major catalyst for a correction that was coming anyway.
–We also pow-wowed with editors Kris Sayce and Alex Cowie and their advice was the same: observe your trailing stops and then, when the time is right, look for a chance to re-establish your position in companies you know and like. Greg Canavan will take over the helm of the DR to give you his view on what to do over the next two days.
—There are two other financial market questions worth considering today. The first is whether Japan’s crisis will lead to rising long-term U.S. bond yields. The Japanese are one of the largest holders of U.S. Treasuries and continue to buy them. That capital might be put to a lot better use in the coming years rebuilding from the quake and tsunami damage.
–Of course in the short term, the “risk off” trade is bullish for U.S. bonds and the U.S. dollar. People are cashing in their chips and storing up their cash. But longer term, the U.S. may find it a lot harder to fund deficits without the help of at least one major foreign buyer. This will put more pressure on the Fed to monetise debt right away.
–Finally, Japan is a big export market for Australian minerals, energy, and agricultural commodities. The table from ABARE’s most recent quarterly report shows just how important an export market Japan is for Australia. So what will the effect of the quake and tsunami be?
–The answer is the effect will be mixed. If Japan’s big exporters slow down production, it will reduce demand for commodity inputs. Of course no one knows yet what Japan’s reconstruction effort will require in terms of base metals. It’s way too early for that.
–For now, the effect is going to be mixed. If Japan idles some of its nuclear plant, it will probably increase LNG and thermal coal imports. Also, if there is serious concern about the safety of Japan’s food supply, agricultural exports from Australia could actually increase. The table below shows that when it comes to energy commodities, Japan is a bigger trading partner to Australia than China.
–So what do we make of all that?
–Well, for now, the Japanese quake is a catalyst for a big correction in the share market. It’s the kind of event that could lead to a change in investor sentiment. That’s negative for Aussie stocks and the Aussie dollar. But once the immediate panic subsides, you’d expect cash to be redeployed into some of the stocks that are now a lot cheaper, and into some of the precious metals.
–The longer-term impact on the global economy and commodities demand is a lot more mixed. And of course the story is still playing out. Asset prices could stabilise if the situation becomes more stable. But if it doesn’t…an even bigger market rout wouldn’t be far around the corner.
For Daily Reckoning Australia